By Nara Bahadur Thapa

Recent global financial crisis has once again ignited the debate on the role of monetary policy in ensuring financial stability. Taking a cue from international trend, emerging financial distress in Nepal has added pressure on using monetary policy instruments for securing financial stability. The question asked is: should financial stability be in the domain of monetary policy or should it be pursued as an objective of regulatory policy? Although the debate remains still inconclusive, views on either side of the debate have sharpened.

Undoubtedly, safeguarding financial stability has become an increasingly dominant objective in economic policy. Hence, it is argued that monetary policy should also take care of it. In light of this, besides maintaining price stability and supporting economic growth, Monetary Policy often has the task of preserving financial stability. Monetary variables such as the quantum of money, bank credit, liquidity and the level of interest rates are used to attain monetary policy objectives.

These monetary variables - the quantum of money, bank credit, liquidity and the level of interest rates - affect financial stability in one way or the other. This is the basis of the argument that monetary policy should be used to safeguard financial stability. In this context, it should be noted that the NRB Act 2002 does not state financial stability as an objective of monetary policy. Monetary policy objectives, as enshrined in the NRB Act 2002, are maintaining low and stable rate of inflation and the external sector stability. These two objectives are supposed to ensure the sustainable development of the economy. Nevertheless, the Act does indicate that the role of the central bank in promoting banking and financial stability as well as developing a secure, healthy and efficient domestic payment system.

We should seek the answer to the question as to why the law of the central bank has not assigned the financial stability as an objective of monetary policy. This implies that the NRB Act has visualized instruments that can be used to ensure monetary and financial stability differently.  

Financial architecture

The way monetary policy is conducted and financial stability is pursued should be discussed in the context of the financial architecture that exists at the global as well as the domestic level. The current international financial architecture is rooted in the McKinnon-Shah hypothesis (1973) that argues for the removal of financial repression and the introduction of financial deregulation. The major elements of financial deregulation are: (i) the elimination of credit controls, (ii) the deregulation of interest rates, (iii) free entry into the banking sector/financial services industry, (iv) central bank autonomy, (v) private ownership of banks and (vi) liberalization of international capital flows.

International organizations such as International Monetary Fund (IMF) and the World Bank supported the McKinnon-Shaw hypothesis and in the process encouraged member nations to adopt liberal financial policies. Many developing countries including Nepal deregulated their financial sector. Even in the USA, the comprehensive regulations introduced in 1933 in the wake of the Great Depression in the form of the Glass-Steagall Act which had ensured financial stability were removed in 1999, ushering in a complete deregulation of the financial sector. The Glass-Steagal Act kept different types of financial institutions separate and dictated the activities they could and could not engage in. It was argued that Glass-Steagall Act prevented banks from diversifying risk. Following this, an agreement was reached at the global level for the international financial architecture.

 

The major elements of which are:

i. Simple rules for monetary and fiscal policy would guarantee macro stability,

ii. Deregulation and privatization would unleash growth and prosperity,

iii.Financial markets would channel resources to the most productive areas and polish themselves effectively, and

iv. The rising tide of globalization would lift all economies.

The agreement on these elements spearheaded by the IMF and the World Bank is known as the Washington Consensus. The spirit is that the adoption of standards and codes on macro-financial policies, transparency, good corporate governance and internationally designed accounting and auditing rules would ensure financial stability. Given these standards, it was thought that market would ensure financial stability. With no restriction on the portfolio, free entry and exit of financial institutions could ensure the dynamic financial stability. There was no need for government intervention, including financial bailout. In keeping with this framework, Lehman Brothers was allowed to fail in September 2008.

With the economic liberalization initiated in the mid-1980s, the Nepali financial system has experienced significant developments. The NRB Act 2002 aims at consolidating the foundation for the new domestic financial architecture. The new NRB Act provides an autonomous central bank answerable to parliament. The Act curtails the unlimited lender of last resort (LOLR) facility for both the government of Nepal and the banking sector as the facility has a danger of creating a perpetual financial instability.

Prudential regulation and supervision for financial stability

Now the question that arises is: What instruments does the NRB Act 2002 envisage to ensure financial stability? The current international financial architecture underscores the importance of prudential regulation and supervision for achieving financial stability. The NRB Act 2002, BAFIA 2004, Debt Recovery Act (DRA) 2002 and Credit Information Bureau (CIB) underpin the new domestic financial architecture. The NRB Act 2002 grants the autonomy to the central bank aimed at strengthening the banking supervision. The BAFIA lays down the framework for banks to operate. The DRA establishes creditors rights. The CIB offers a venue for information sharing among banks with a view to help reduce non-performing loans (NPL). This is key to ensure financial stability over the period.

The case for the use of monetary policy for financial stability

The recent global crisis showed that prudential regulation and supervision alone did not guarantee financial stability. Hence, a case is made for using monetary policy in support of financial stability. In the wake of the recent global crisis, the IMF urged member nations to use monetary policy as the first line of defense.

Given the importance of financial sector stability for the overall functioning of macro economy in general and the transmission mechanism of monetary policy in particular, the NRB is cognizant of the role of monetary policy in attaining financial stability in recent years. Accordingly, monetary policy instruments have been used in support of financial stability. For instance, the bank rate, which was as high as 9 percent some years ago, was gradually reduced to 5.5 percent. Currently, it is 7 percent. Recently, the penal rate of 3 percent has been added to it for the LOLR facility to banks.

Besides the bank rate, concessional refinancing rates have been lowered to 1.5 percent for exporters, sick industries, small and medium scale industries and targeted people for foreign employment. The NRB has been making a provision for refinancing banks for their sick industry loans over the last several years. The objective is to help financial institutions and thereby achieve financial stability.

The cut in CRR has been consistently and systematically aimed at reducing the financial intermediation cost. The argument in this case is that monetary policy in no way should be a factor responsible for a higher financial intermediation cost measured in terms of interest rate spread. For this reason, CRR has been systematically reduced from 12 percent a few years ago to the current level of 5.5 percent.

A system of flexible open market operations aimed at modulating liquidity has been put in place since 2004/05. Open market monetary instruments such as sale, purchase, repo and reverse repo auctions are being used either to inject or drain liquidity from the system.

A system of standing liquidity facility (SLF) has been introduced for counterparties. The purpose of the SLF is to provide a safety valve for domestic payments system. Under this facility, counterparties can make an automatic and hassle - free access to funds from the central bank.

The case against overly use of monetary policy for financial stability

There are counter arguments for overly use of monetary policy for financial stability. First, it is argued that the mixed role of the central bank, namely securing banking stability and maintaining monetary stability, at times, creates policy tensions. For example, the use of accommodative monetary stance aimed at supporting financial stability could be counterproductive to price and external stability in the face of pressures on inflation front and a deficit in country's BOP position. As such, the central bank faces policy tensions of using soft interest rate policy for securing financial stability or hard interest rate policy for keeping inflation low and maintaining external stability.

Second, as per Tinbergin's rule (one instrument - one target), monetary policy, which is one instrument, can not be used for two policy goals - monetary stability and financial stability.

 Third, rescuing financial institutions by way of soft interest rate policy or the protracted use of quantitative easing through the LOLR facility will only prolong financial imbalances, posing risks to financial stability over the medium term. This will only postpone financial distress leading to a bursting of financial crisis in some points of time in the future. In this context, Greenspan's prolonged low interest rate policy is cited as one of the causes of the financial crisis in the US in 2008.

Fourth, it is argued that the expectation of monetary authorities stepping in to defuse a crisis undermines market discipline and creates moral hazard problem in that it weakens the incentive for market participants to act prudently.

Fifth, as Greenspan argued, the cleaning up the mess after the bubble bursts would be technically easier and less interfering with the market and more cost effective.

Back home in Nepal, it is argued that excessive monetary injection by way of repo and SLF lending helped perpetuate low interest rate regime in the past. This encouraged banks to indulge in financial excesses, leading to the recent financial distress in Nepal, including a deficit in country's BOP. It must be noted that the deficit in BOP during the last two years is not on account of the government budgetary imbalances, it is due to the private sector excesses and imbalances. 

Of the various facts of financial stability, the question of monetary policy taking care of real estate and share prices has remained controversial. The question often asked is as to what should be the role of monetary policy in keeping these prices stable. This question is asked because stock market developments generate wealth effects, which have monetary policy implications. Likewise, stock market developments have implication for NPA level and, at times, threaten banking sector stability. Foreign portfolio investment in stocks has implication for external stability, for a greater volatility in share prices causes a sudden capital outflow, leading to BOP and exchange rate crises. Since foreign portfolio investment in the Nepalese stock market does not exist, this kind of tension does not arise in Nepal as for now. The consensus so far reached is that monetary authorities should be watchful of these prices. However, it is argued that monetary policy should not be overly used in containing these prices.

Macro prudential regulation

Micro prudential regulation does not make a distinction between growth enhancing credit and speculative ones. The consensus is also not to use monetary policy overly for financial stability. Hence, the focus has now shifted on macro prudential regulation. It is argued that macro prudential regulation is needed to deal with the issue of pro-cyclicality and build defenses against emerging structural vulnerability in the financial sector. Pro-cyclicality and structural vulnerability are manifested in terms of real estate bubbles, common exposure to asset price bubbles, excessive leverage and low level of liquidity. To deal with these problems, macro prudential measures such as capital ratios, capital buffers, dynamic (forward looking) provisioning, liquidity ratios and prudent collateral valuation are applied. According to Blanchard, in case, excessive leverage emerges, regulatory capital ratio should be raised. If liquidity is low, regulatory liquidity ratio should be increased. If housing prices are rising, loan-to-value (LTV) ratio should be lowered. If stock prices are rising, margin requirements (haircuts) should be raised. In the wake of emerging financial distress, the NRB has introduced a number of macro prudential measures. For example, sectoral loan limit for housing sector is capped at 25 percent and real estate at 10 percent. C-D ratio for banks and financial institutions is fixed at 80 percent. The LTV ratio for shares has been fixed at 60 percent. Similarly, the LTV ratio has been fixed at 60 percent for both real estate and housing.

Although macro prudential regulation could act as the first line of defense and be an important element of new financial architecture in the wake of the recent global financial crisis, there is a possibility of strong political pressure against the use of it. In the US, the delay in adopting the Volcker plan which aims at separating functions of different financial institutions is an example of it. Back home in Nepal, the strong pressure for the removal of LTV ratio for shares and strong lobby for the relaxation of capping real estate and housing loans are cases in point. This suggests that the existing domestic financial architecture will remain intact, implying that only micro prudential norms and market discipline will remain instruments for financial stability. There will be growing demand for the excessive use of monetary policy for securing financial stability. However, the latter will not help safeguard the long term financial stability. If it is used, it will be only at the peril of macroeconomic stability.

Tentative conclusions

There is no doubt that financial stability is a public good which must be secured through preventive and remedial measures. Micro - macro prudential and deposit insurance measures can be applied to maintain financial stability. Keeping monetary conditions at an appropriate level is also key to securing financial stability. For example, easy liquidity conditions would encourage banks to take excessive risks by overindulging in lending. This happened in Nepal in the recent past. Likewise, overly tight liquidity conditions would lead to financial distress. Both of these monetary conditions should be avoided.

Therefore, going forward, the NRB will, in due course of time, appropriately streamline monetary operations. For example, there are ample instruments for the injection of liquidity. However, there are few to drain it. Sale and reverse repo auctions fall short of draining liquidity due to various reasons. Hence, the NRB will seek rationale in introducing standing deposit facility for banks as and when situation warrants.

The creation of standing deposit facility entails bearing financial costs by the central bank. Therefore, it requires strengthening the financial position of the central bank. It is especially important in relation to the growing size of counterparties and liquidity that would be needed to drain. One way of improving financial position of the central bank for the operation of deposit facility is increasing its paid up capital from the current three billion rupees to five billion rupees. This will help the NRB to absorb possible losses arising from monetary operations.

The exchange rate and the interest rate are the fundamental macro variables. As the current exchange rate regime as being used as the nominal anchor for macroeconomic management, there is no question of disturbing it at this stage. Therefore, given the depth and breadth of the domestic financial sector development so far, the interest rate is slowly emerging as key policy variable for macro-financial management. In this context, a need has been felt for using short term interest rate instead of the quantity of liquidity as an operating target. The NRB will pursue this in due course of time.

The role of monetary policy becomes crucial when preventive measures fail to ensure financial stability. Therefore, the role of monetary policy should come at the remedial stage. This is the market failure stage. When this stage comes, as the past intervention indicates, the NRB is extremely cautious to distinguish between those having solvency problem and those with liquidity problem. The LOLR facility should be provided to those solvent but with liquidity problem.

Given the current financial architecture, the NRB's intervention will take place only when market fails to ensure financial stability. Therefore, the NRB intervention, for that matter, will come with strings such as merger, management change, improvement in corporate governance etc. If financial institutions with solvency problem are systemic, the government should intervene by way of either injecting capital or guaranteeing deposits. Otherwise as per the spirit of the current domestic financial architecture, such financial institutions should be liquidated.

In case, the financial distress continues and additional LOLR facility is called for, Nepal will have to negotiate for the IMF program. This will be inevitable to deal with the possible adverse impact of LOLR facility on international reserves and BOP.

Summing up

The kind of domestic financial architecture we have chosen is key to consider the role of monetary policy for financial stability. If we were to adopt liberal licensing policy and allow banks to have portfolio of their choice, micro prudential, self regulation and market discipline should be key for financial stability. The focus of monetary policy should be on inflation, BOP and foreign exchange. These are crucial areas for attaining macroeconomic stability including financial stability. The role of monetary policy should be marginal and come at the remedial stage. Those financial institutions which cannot survive on their own under the liberal framework of financial architecture should be allowed to disappear. If we were to seek a larger role of monetary policy in ensuring financial stability we will have to be willing to change the current financial architecture including readiness to adopt macro prudential regulation. Given the existing framework of the financial architecture, any lobbying for political interference for the change in monetary policy is construed as an attack on professionalism and autonomy of the central bank. This does not bode well for market discipline, a crucial element for financial stability either.

(Thapa is the Chief Manager at Biratnagar Office of Nepal Rastra Bank (NRB). He was earlier the Director of Research Department at NRB's central office in Baluwatar, Kathmandu. He also spent two years between 2008 and 2010 as Advisor to the Executive Director at International Monitory Fund (IMF), Washington DC, prior to returning to Nepal.)